Arnold Kling asks the following in Education vs. Money Management:
Consider the following two propositions, one in education (E) and one in finance (F).
(E) One way to improve education would be to get rid of the bottom 10 percent of teachers and to try to replicate more widely the techniques used by the top 10 percent of teachers.
(F) One way to improve financial markets would be to get rid of the bottom 10 percent of money managers and to try to replicate more widely the techniques used by the top 10 percent of money managers.
What is interesting is that I know many economists who believe (E), although they may be skeptical that the best teaching can be replicated. However, I do not know any economists who believe (F).
(h/t Karl Smith who has additional comments.)
Is (F) obviously false? As I read the question: Will the bottom 10% of money managers do worse time over time? It’s not obviously false. Remember that efficient markets – in the strong, Fama and Friedman sense of efficient financial markets – are not efficient because every manager pulls the same portfolio, they are efficient through arbitrage opportunities. If there are noise traders, smart arbitrageurs will cancel their positions out. They could be driven out of the market, though that isn’t necessary. If a manager is dumb, he or she could likely be dumb in the next time period as well, but that manager could be able to continue to attract investors for non-fundamental financial reasons.
This allows for a very strong efficient market theory that allows distributional consequences. If there are, as the kids say, limits to how effortlessly arbitrage works in financial markets, or if noise traders introduce risks into markets that the assets don’t compensate, we can see certain “anomalies” in asset price movements. Mutual fund or hedge fund managers who take advantage of said anomalies could get better performance if they lean into the anomalies, and worse if they lean against, though it isn’t clear what type of “skill” that is.
It’s been a while since I’ve been on the frontier of cutting edge research into the financial econometrics of the distribution of mutual fund performance. (I was so young back then.) I’m pretty sure this research survives into the Great Recession and financial market collapse.
Let’s go to a personal favorite, Mark M. Carhart, On Persistence in Mutual Fund Performance The Journal of Finance, March 1997 (my bold):
Using a sample free of survivor bias, I demonstrate that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual fund’s mean and risk-adjusted returns. Hendricks, Patel and Zeckhauser’s (1993) “hot hands” result is mostly driven by the one-year momentum effect of Jegadeesh and Titman (1993) but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers….
This article does much to explain short-term persistence in equity mutual fund returns with common factors in stock returns and investment costs. Buying last year’s top-decile mutual funds and selling last year’s bottom-decile funds yields a return of 8 percent a year. Of this spread, differences in the market value and momentum of stocks held explain 4.6 percent, differences in expense ratios explain 0.7 percent, and differences in transaction costs explain 1 percent…
Although the top-decile mutual funds earn back their investment costs, most funds underperform by about the magnitude of their investment expenses. The bottom-decile funds, however, underperform by about twice their reported investment costs. Apparently, these results are not confined to mutual funds: Christopherson, Ferson, and Glassman (1995) reach qualitatively similar conclusions about pension fund performance. However, the severe underperformance by the bottom-decile mutual funds may not have practical significance, since they are always the smallest of the funds….
The evidence of this artcile suggests three important rules-of-thumb for wealth-maximizing mutual fund investors: (1) Avoid funds with persistently poor performance; (2) funds with high returns last year have higher-than-average expected returns next year, but not in years thereafter….
As of that paper, there is visible persistence in mutual fund performance. Media loves to talk about killer mutual fund analysts who beat the market. And this does exist. Does that mean mutual fund managers have skill? What Carhart did was re-examine the results controlling for survivorship bias and, crucially, already known-anomalies within asset price movements. With that in mind he found that mutual fund managers add no value – all they do is replicate already known anomalies, that come with their own debate about market imperfections, risk-weighting, etc. as well as eat up a lot of costs, costs that cancel value added.
The only exception comes with the bottom decile and top decile. Crucially, the top decile doesn’t add value when you consider the extra fees they charge. The bottom decile does far worse consistently. Key chart:
On that evidence I would tentatively accept (F). Stay away from the bottom barrel of money managers.